Whether an instrument is classified as either a financial liability (debt) or as equity is important, as it has a direct effect on an entity’s reported results and financial position:
- Liability classification affects an entity’s gearing ratios and typically results in any payments being treated as interest and charged to earnings.
- Equity classification avoids these impacts, but may be perceived negatively by investors if it is seen as diluting their existing equity interests.
Under IAS 32 a financial liability is:
- A contractual obligation:
- to deliver cash or another financial asset to another entity; or
- to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavorable to the entity; or
- A contract that will or may be settled in an entity’s own equity instruments.
IAS 32 clarifies that an instrument is only an equity instrument if neither (1) nor (2) in the definition of a financial liability are met.
Entity X has in issue two classes of shares: A shares and B shares. The A shares are correctly classified as equity.
Entity X is obliged to pay an annual dividend of 7% on the B shares. The dividend payment is cumulative even if the entity does not have sufficient legally distributable profits at the time the payment is due.
B shares would be treated as a financial liability, since they contain an obligation to deliver cash in the form of a fixed dividend. The dividend is cumulative and must be paid whether or not Entity X has sufficient legally distributable profits when it is due, and so the entity cannot avoid this obligation.
Entity X issues an instrument for which it receives $200.000. Under the terms of the issue, Entity X will repay the debt in 4 years by delivering ordinary shares to the value of $220.000.
In this case, Entity X is using its own shares as currency, and the instrument should therefore be classified as a financial liability.
Entity X has two classes of shares: Class A and Class B shares. The Class A shares are Entity X’s ordinary shares and qualify for equity classification.
The Class B shares are not mandatorily redeemable shares, but contain a call option allowing Entity X to repurchase them. Dividends are payable on the Class B shares if and only if dividends have been paid on the Class A ordinary shares.
The instrument should be classified as equity as there is no contractual obligation to pay the dividends or to call the instrument.